class: center, middle, inverse, title-slide .title[ # Principles of Macroeconomics ] .author[ ### ECO 2307 ] .date[ ### <em>Spring 2023</em> ] --- class: center, middle, inverse # Chapter 15 ## Monetary Policy <img src="data:image/png;base64,#images/qr_codes/QR6.png" width="40%" style="display: block; margin: auto;" /> <!-- --- --> <!-- ## The Fed Deals with Two “Once in a Lifetime” Crises in 15 Years --> <!-- The financial crisis of 2007–2009 was the first to hit the United States since the bank panics of the early 1930s. --> <!-- The Covid-19 pandemic of 2020–2021 was the first disease outbreak to push the U.S. economy into a recession since the 1918 influenza pandemic. --> <!-- Many experts believe the Fed’s rapid responses to both events saved the financial system from collapse and limited the severity of the recessions. --> <!-- However, the Fed actions were not without criticism. --> --- ## What Is Monetary Policy? .panelset[ .panel[.panel-name[Role of Fed] #### Where we've been... - who the Fed is - monetary policy tools they use #### What Is the Role of the Federal Reserve? - Created (1913) to prevent bank runs - Great Depression (1930s) - Broader responsibilities - "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates" - Since World War II, active monetary policy **Monetary policy:** the actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives ] .panel[.panel-name[Goals] #### The Goals of Monetary Policy The Fed pursues four main monetary policy goals: 1. Price stability - Rising prices reduces purchasing power - Volcker (1970s) used monetary policy to address inflation - Don't really emphasize anymore 2. High employment - Employment act of 1946 - Price stability + high employment = **dual mandate** 3. Stability of financial markets and institutions - Makes funds available to banks in crises 4. Economic growth - **Stable** economic growth => long-run investment => growth - Not clear how Fed helps outside of 1-3 ] ] --- ## The Fed’s Choice of Monetary Policy Targets .panelset[ .panel[.panel-name[Intro] #### 3 monetary policy tools for unemployment/inflation: 1. Open market operations 2. Discount policy 3. Reserve requirements Done by influencing **monetary policy targets:** - The money supply - The interest rate (primary monetary policy target of the Fed) ] .panel[.panel-name[Money Demand] .pull-left[ #### The Demand for Money <img src="data:image/png;base64,#images/fig_15_2.png" width="100%" style="display: block; margin: auto;" /> ] .pull-right[ #### Shifts in the Money Demand Curve <img src="data:image/png;base64,#images/fig_15_3.png" width="100%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[How Manage] ### How Does the Fed Manage the Money Supply? Fed alters the money supply with **open market operations** - buying/selling U.S. Treasury securities - Increase the money supply, - the Fed buys those securities; - the sellers deposit the sale proceeds in a checking account; and - the money gets loaned out—increasing the money supply - Decreasing the money supply would require selling securities ] .panel[.panel-name[Interest Rate] .pull-left[ **The Effect on the Interest Rate When the Fed Increases the Money Supply** <img src="data:image/png;base64,#images/fig_15_4.png" width="100%" style="display: block; margin: auto;" /> ] .pull-right[ **The Effect on the Interest Rate When the Fed Decreases the Money Supply** <img src="data:image/png;base64,#images/fig_15_5.png" width="90%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[Rate Options] ### A Tale of Two Interest Rates #### The loanable funds model (Chapter 10) - Concerned with long-term real rate of interest - Relevant for long-term investors (firms making capital investments, households building new homes, etc.) #### The money market model (this chapter) - Concerned with short-term nominal rate of interest - Most relevant for the Fed: changes in money supply directly affect this interest rate Usually, the two interest rates are closely related; an increase in one results in the other increasing also. ] .panel[.panel-name[Target] ### Choosing a Monetary Policy Target .pull-left[ - Money supply or short-term nominal interest rate - **federal funds rate:** interest rate banks charge each other for overnight loans - Fed doesn't set rate - Fed affects supply of bank reserves through open market ops ] .pull-right[ <img src="data:image/png;base64,#images/fig_15_6.png" width="100%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[] ### Choosing a Monetary Policy Target The Fed can choose to target a particular level of the money supply or a particular short-term nominal interest rate. It concentrates on the interest rate, in part because the relationship between the money supply (M1 or M2) and real GDP growth broke down in the early 1980s (M1) and 1990s (M2). There are many different interest rates in the economy; the Fed targets the federal funds rate: The interest rate banks charge each other for overnight loans. The Fed does not set the federal funds rate, but rather affects the supply of bank reserves through open market operations. ] .panel[.panel-name[] ### Figure 15.6 The Federal Funds Rate Since 1954 Although it does not directly set the federal funds rate, through open market operations the Fed can control it quite well. The Fed pushes the federal funds rate down during recessions to encourage high employment and up during expansions to encourage price stability. New Policy Tools: Paying Interest on Reserves During and after the financial crisis of 2007-2009, bank reserves soared, reaching $2.8 trillion in 2014. Bank reserves fell back to $1.5 trillion by September 2019 but surged to $3.9 trillion by April 2021. This limits the Fed’s ability to raise interest rates through open market sales. Instead, the Fed began paying banks interest on their reserve holdings. The interest rate it pays sets a floor on the federal funds rate. Why? If the federal funds rate were much lower than the interest rate on reserve balances, banks could borrow funds in the federal funds market, deposit them at the Fed, and earn risk-free profit. Such actions are not actually costless, though, so the effective floor is below the interest rate on reserves. Rather than conducting open market purchases and sales, the Fed sometimes engages in temporary transactions called repurchase agreements. The Fed buys a security from a financial firm, which promises to buy it back the next day. A reverse repurchase agreement does the reverse, effectively borrowing money from that firm overnight. By raising the interest rate the Fed pays on these loans, it reduces the willingness of the firms to lend at a lower rate. Using these new policy tools, the Fed keeps the federal funds rate in a target range: 2.25%-2.50% in late 2018. ] .panel[.panel-name[Policy Tools] #### Paying interest on reserves - What happens when bank reserves rise? - Limits Fed's ability to raise interest rates through open market sales - So Fed started paying banks' interest - This sets the floor on federal funds rate #### Repurchase Agreements and Reverse Repurchase Agreements - repurchase agreements: - Fed buys a security from a financial firm - firm promises to pay back next day - Reverse repurchase agreement: - opposite of repurchase agreements - Fed borrows and promises to pay back next day - Target range: 2.25%-2.50% as of 2018 ] ] ??? The Fed’s two monetary policy targets are related in an important way: - Higher interest rates result in a lower quantity of money demanded. Why? - When the interest rate is high, alternatives to holding money begin to look attractive—like U.S. Treasury bills. - So the opportunity cost of holding money is higher when the interest rate is high. #### Figure 15.3 Shifts in the Money Demand Curve What could cause the money demand curve to shift? - A change in the need to hold money, to engage in transactions. For example, if more transactions are taking place (higher real G D P) or more money is needed for each transaction (higher price level), - the demand for money will be higher. - Decreases in real G D P or the price level decrease money demand. #### Interest Rate - Figure 15.4 The Effect on the Interest Rate When the Fed Increases the Money Supply - For simplicity, we assume the Fed can completely control the money supply. - Then the money supply curve is a vertical line--it does not depend on the interest rate. - Equilibrium occurs in the money market where the two curves cross. - When the Fed increases the money supply, the short-term interest rate must fall until it reaches a level at which households and firms are willing to hold the additional money. - Figure 15.5 The Effect on the Interest Rate When the Fed Decreases the Money Supply - Alternatively, the Fed may decide to lower the money supply by selling Treasury securities. - Now firms and households (who bought the securities with money) hold less money than they want, relative to other financial assets. - In order to retain depositors, banks are forced to offer a higher interest rate on interest-bearing accounts. --- ## Monetary Policy and Economic Activity .panelset[ .panel[.panel-name[Intro] #### How well the Fed's can affect things - ability to affect economic variables (e.g., real GDP) - depends on long-term interest rates #### How does the Fed do this? - federal funds rate (a short-term nominal interest rate)--an imperfect tool - We assume in this section that the Fed can affect long-term real interest rates using the federal funds rate ] .panel[.panel-name[AD & Interest] ### How Interest Rates Affect Aggregate Demand .pull-left[ **Consumption** 1. `\(\downarrow\)` interest rates => `\(\uparrow\)` credit use - `\(\uparrow\)` credit use affects sale of durables 2. `\(\downarrow\)` interest rates => `\(\downarrow\)` saving **Investment** 1. `\(\downarrow\)` interest rates => `\(\uparrow\)` capital investment by firms by making - it cheaper to borrow (sell corporate bonds) - stocks more attractive for households to purchase, so firms `\(\uparrow\)` funds by selling more stock 2. Lower rates encourage new residential investment ] .pull-right[ **Net exports** - High U.S. interest rates - attract foreign funds - raising the US exchange rate - causing net exports to fall ] ] .panel[.panel-name[Monetary Policy] .pull-left[ <img src="data:image/png;base64,#images/fig_15_7a.png" width="100%" style="display: block; margin: auto;" /> ] .pull-right[ <img src="data:image/png;base64,#images/fig_15_7b.png" width="100%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[] ### Apply the Concept: Quantitative Easing, the Fed’s Balance Sheet, and Negative Interest Rates in Europe (1 of 3) Adjusting the federal funds rate had been an effective way for the Fed to stimulate the economy, but it began to fail in 2008. Banks did not believe there were good loans to be made, so they refused to lend out reserves, despite the federal funds rate being maintained at zero. This is known as a liquidity trap: the Fed was unable to push rates any lower to encourage investment. But the Fed was certain the economy was below potential GDP, so it wanted to stimulate demand. It performed quantitative easing several times: buying securities beyond the normal short-term Treasury securities, including 10-year Treasury notes and mortgage-backed securities. This dramatically changed the Fed’s balance sheet. The use of QE by the Fed and other central banks led to historically low interest rates in most countries. In the U.S., real interest rates were at or below zero. In Germany, France, Ireland, and Switzerland, even nominal interest rates fell below zero at times. The Fed opted to use other policy tools during the Covid-19 pandemic. ] .panel[.panel-name[No Recessions?] ### Can the Fed Eliminate Recessions? In our demonstration of monetary policy, the Fed - knew how far to shift aggregate demand, and - was able to shift aggregate demand exactly this far In reality, monetary policy is hard to get right - Completely offsetting a recession is *not realistic* - the actual goal is to make recessions *milder* and *shorter* Another complicating factor - *current* economic variables are rarely known - we usually can only know them for the *past*—i.e. with a *lag.* - Example: Nov. 2001, NBER announced a recession began in March 2001 - several months later, it announced the recession ended… in November 2001 ] .panel[.panel-name[Bad Timing] #### The Effect of a Poorly Timed Monetary Policy on the Economy <img src="data:image/png;base64,#images/fig_15_8.png" width="50%" style="display: block; margin: auto;" /> ] .panel[.panel-name[Forecasts] #### Fed Forecasts of Real GDP Growth During 2007 and 2008 <img src="data:image/png;base64,#images/tab_15_1.png" width="100%" style="display: block; margin: auto;" /> ] .panel[.panel-name[] ### Apply the Concept: Trying to Hit a Moving Target As if the Fed’s job wasn’t hard enough, it also has to deal with changing estimates of important economic variables. GDP from the first quarter of 2008 was initially estimated to have increased by 0.6 percent. But the estimate changed over time. Not only was it revised later in 2008, it was revised in 2009, 2011, in 2013, and even again in 2018! ] .panel[.panel-name[Types] ### Expansionary and Contractionary Monetary Policies <img src="data:image/png;base64,#images/fig_15_9.png" width="98%" style="display: block; margin: auto;" /> ] ] ??? **Captial investment** - Capital investment is the expenditure of money to fund a company's long-term growth. - The term often refers to a company's acquisition of permanent fixed assets such as real estate and equipment. - Capital assets are reported as non-current assets and most are depreciated. - The funds for capital investment can come from a number of sources, including cash on hand, though big projects are most often financed through obtaining loans or issuing stock. - Examples of capital investments are land, buildings, machinery, equipment, or software. --- ## Monetary Policy in the Dynamic Aggregate Demand and Aggregate Supply Model .panelset[ .panel[.panel-name[Overview] We used the static AD-AS model initially for simplicity - in reality, potential GDP increases every year (long-run growth) - the economy generally experiences inflation every year So we use the *dynamic aggregate demand/supply (AD/AS) model* Recall, this features: - Annual increases in long-run aggregate supply (potential GDP) - Typically, larger annual increases in aggregate demand - Typically, smaller annual increases in short-run aggregate supply - Typically, therefore, annual increases in the price level ] .panel[.panel-name[Expansionary] .pull-left[ <img src="data:image/png;base64,#images/fig_15_10.png" width="100%" style="display: block; margin: auto;" /> ] .pull-right[ <img src="data:image/png;base64,#images/fig_15_11.png" width="120%" style="display: block; margin: auto;" /> ] ] ] --- ## Closer Look at Setting Monetary Policy Targets .panelset[ .panel[.panel-name[Monetarism] .pull-left[ #### Targeting fed funds rate - Normally, the Fed targets the federal funds rate - Alternative target is money supply - Which should it use? #### Should the Fed Target the Money Supply? - Monetarists, (e.g. Milton Friedman) said “yes” - monetary growth rule: `\(\uparrow\)` money supply at same rate as LR real GDP growth - active countercyclical monetary policy destabilizes the economy - monetary growth rule would provide stability instead ] .pull-right[ #### Rise and fall of monetarism - popular in the 1970s - post-1980s, money supply and real GDP seem less correlated: - M1 changes “wildly” - real GDP and inflation do *not* react in the same way - Now, targeting the money supply is not seriously considered ] ] .panel[.panel-name[Targets] <img src="data:image/png;base64,#images/fig_15_12.png" width="50%" style="display: block; margin: auto;" /> ] .panel[.panel-name[Taylor Rule] .pull-left[ **Taylor Rule ** $$ `\begin{aligned} \textit{Fed funds target rate} =& \textit{Current inflation rate} \\ &+ \textit{Equilibrium real fed funds rate} \\ &+ \bigg( \frac{1}{2} \times \textit{Inflation gap} \bigg)\\ &+\bigg( \frac{1}{2} \times \textit{Output gap} \bigg) \end{aligned}` $$ ] .pull-right[ #### Components of the **Taylor Rule** - **Equilibrium real fed funds rate** - estimate of inflation-adjusted fed funds rate - this would maintain real GDP at potential level in LR - **Inflation gap** - difference between current inflation and the Fed’s target rate of inflation - could be positive or negative - **Output gap** - difference between current real GDP and potential GDP - could be positive or negative ] ] .panel[.panel-name[Target Inflation] ### Should the Fed Target Inflation Instead? .pull-left[ **Inflation targeting: ** - framework for conducting monetary policy - involves the central bank announcing its target level of inflation **Policy adoption** - adopted by central banks in some other countries - Bank of England - European Central Bank - typical outcome of inflation targeting - inflation is lower - unemployment is (temporarily) higher ] .pull-right[ <img src="data:image/png;base64,#images/ch_15/target_inflation.png" width="70%" style="display: block; margin: auto;" /> **2012 Example** - the Fed announced first explicit inflation target - an average inflation rate of 2% per year ] ] .panel[.panel-name[Debate] ### Arguments for and Against Inflation Targeting .pull-left[ #### For Inflation Targeting: - Clear that Fed cannot affect real GDP in long run - Easier for firms/households to form expectations about future inflation (planning improves) - Promotes Fed account-ability - provides a yardstick to measure performance ] .pull-right[ #### Against Inflation Targeting: - Reduces Fed’s accountability and flexibility to address other policy goals - Assumes Fed can correctly forecast inflation rates - Increased focus on inflation rate may result in Fed being less likely to address other beneficial goals ] ] .panel[.panel-name[] ### Apply the Concept: Should the Fed Worry about the Prices of Food and Gasoline? (1 of 2) Which inflation rate does the Fed actually pay attention to? Not the C P I: it is too volatile and probably overstates inflation. It used to use the P C E (personal consumption expenditures) index, a broad price index similar to the GDP deflator. Which inflation rate does the Fed actually pay attention to? Since 2004, it has used the “core P C E”: the P C E without food and energy prices. The core P C E is more stable; the Fed believes it estimates true long-run inflation better. ] .panel[.panel-name[Target Nominal GDP] ### Should the Fed Target Nominal GDP? **Other economists and policymakers have suggested "yes"** .pull-left[ **Example: ** - Suppose Fed - expects 3% annual real GDP growth - wants 2% inflation - Then, it would target 5% nominal real GDP growth ] .pull-right[ **Expansionary v. Contractionary Policy** - If real GDP growth slowed, the policy would be **expansionary** - If real GDP growth was faster than expected, the policy would be **contractionary** - Targeting nominal GDP is similar to a monetary growth rule ] <br> **Application in real world: ** - Since 2019, many central banks adopted inflation targeting - while none had yet adopted nominal GDP targeting ] ] --- ## Fed Policies During the 2007-2009 Recession .panelset[ .panel[.panel-name[Intro] .pull-left[ **Bubbles** - prices are too high relative to the underlying value of the asset **Bubbles can form due to:** 1. **Herding behavior:** - Failing to correctly evaluate value of an asset - by relying on other people’s evaluations 2. **Speculation:** - Believing that prices will rise even higher - And buying the asset intending to sell it before prices fall **Example:** Stock prices of Internet-related companies were “optimistically” high in late 1990s ] .pull-right[ **Housing market bubble formed 2005** - `\(\uparrow\)` prices - `\(=> \uparrow\)` investment in new home construction - `\(=> \uparrow\)` optimistic sub-prime loans **During 2006 and 2007** - house prices started `\(\downarrow\)` (mortgage defaults) - new home construction fell considerably - banks became less willing to lend - resulting credit crunch further depressed the housing market ] ] .panel[.panel-name[GSEs] ### The Changing Mortgage Market **Traditional Mortgage Market** - Recall our discussion from last chapter - Until the 70s, - commercial banks would “keep” the mortgage until it was paid off - This limited the number of mortgages banks were willing to provide **Effect of Government-Sponsored Enterprises (GSEs)** - Secondary mortgages market was made possible with formation of - the Federal National Mortgage Association (“Fannie Mae”) - the Federal Home Loan Mortgage Corporation (“Freddie Mac”) - sell bonds to investors - use the funds to purchase mortgages from banks - this allowed more funds to flow into mortgage markets ] .panel[.panel-name[Investment Banks] .left-column[ <br> <br> <img src="data:image/png;base64,#images/ch_15/investment_banking.gif" width="100%" style="display: block; margin: auto;" /> ] .right-column[ **The Role of Investment Banks (2000s)** - started buying mortgages - packaged as mortgage-backed securities - resell to investors **Securitization was appealing to investors ** - high interest rates - apparently low default risk **Introduction of "worse" loans:** - worse credit histories (sub-prime loans) - no evidence of income (“Alt-A” loans) - lower down-payments - couldn’t initially afford traditional mortgages (adjustable-rate mortgages start with low interest rates) **All of this increased downside risk** ] ] .panel[.panel-name[] ### Apply the Concept: The Wonderful World of Leverage Why does the size of the down payment matter? By owning a house, you become exposed to increases or decreases in the price of that large asset. With a smaller down payment, you are said to be highly leveraged, exposed to large potential changes in the value of your investment. ] .panel[.panel-name[Bad Loans] .pull-left[ ### Result of Lower Quality Loans **Housing bubble burst** - a lot of lower quality loans were defaulted on - more defaults than investors expected **Mortgage-backed securities market** - became very *illiquid* - few people or firms were willing to buy them - prices fell quickly - Investors - Commercial and investment banks - Suffered heavy losses ] .pull-right[ <img src="data:image/png;base64,#images/ch_15/market_bubble_fire.gif" width="80%" style="display: block; margin: auto;" /> **How bad was it?** - The Fed and the U.S. Treasury took unprecedented actions - Bailouts ] ] .panel[.panel-name[Actions] ### Treasury and Fed Actions at the Beginning of the Financial Crisis <img src="data:image/png;base64,#images/tab_15_2.png" width="70%" style="display: block; margin: auto;" /> ] .panel[.panel-name[...] ### Treasury and Fed Actions at the Beginning of the Financial Crisis <img src="data:image/png;base64,#images/tab_15_2b.png" width="75%" style="display: block; margin: auto;" /> ] .panel[.panel-name[Lehman] **Moral hazard** - lack of incentive to guard against risk where one is protected from its consequences - many economists were critical of the Fed underwriting Bear Stearns - managers would now have less incentive to avoid risk - a *moral hazard* problem .pull-left[ **Responses to the Failure of Lehman Brothers** - September 2008, - the Fed did *not* step in to save Lehman Brothers - Supposed to signal to firms not to expect the Fed to save them from their own mistakes - September 15, 2008: Lehman Brothers declared bankruptcy - Financial markets reacted *adversely*--more strongly than expected ] .pull-right[ **American International Group (AIG)** - a few days after Lehmen, AIG began to fail - the Fed reversed course - provided AIG with $85 billion loan ] ] .panel[.panel-name[TARP] .pull-left[ **The Introduction of TARP** - Lots of troubles in the banking system - This led Congress to pass the Troubled Asset Relief Program (TARP) - Provides funds to banks in exchange for stock (unprecedented action) **New forms of intervention** - each of these were unprecedented actions - all designed to achieve traditional macroeconomic goals: - high employment - price stability - financial market stability ] .pull-right[ <img src="data:image/png;base64,#images/ch_15/tarp.png" width="100%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[COVID-19] **Fed Response to Covid-19** - Cut its target for the fed funds rate to zero - Introduced temporary lending facilities - This allows Fed to make loans to businesses other than the commercial banks - They can borrow from the Fed using discount loans **Types of Facilities** - The Fed used both - lending facilities (to banks) - credit facilities (to non-financial firms and state/local governments) - Allowed the Fed to ensure that funds flowed to entities that would have struggled borrowing (firms and state/local governments) **Result:** largely avoided a credit crunch unlike 2007-2009 recession ] ]